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We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive.Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium?We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow.The magnitude of the relationship depends on insider ownership in a nonmonotonic way.Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring.Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets.We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.

Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK